July 2012

After some speculation last week about a compromise being made on appropriations, a deal has tentatively agreed upon between House Speaker John Boehner (R-OH) and Senate Majority Leader Harry Reid (D-NV). The agreement consists of a six-month continuing resolution to fund the government through next March at the Budget Control Act level of $1.047 trillion, up from the $1.043 trillion cap for 2012.

There certainly is relief that FY 2013 (for now) will not have the kind of high-stakes drama that has characterized the budget process since the spring of 2011. But the appropriations deal does nothing to eliminate the fiscal cliff—the Bush tax cuts and the sequester still remain. It was unlikely that either Republicans or Democrats would risk shutting down the government during an election year but the policies of the fiscal cliff are due to be far more controversial.

Add next March to the run of important dates next year when difficult decisions will need to be made. With these potential points of crisis, however, comes great opportunity. This is the best time to get a deal done and finally put debt on a downward path. Lawmakers should come together and get a deal as soon as possibly.

OMB's Mid-Session Review, which was released on Friday, showed lower debt and deficits over ten years than did the President's budget. Our paper on the MSR also went into (mostly) economic and technical reasons why the MSR estimate differed from the February estimate of the President's budget.

Much of it has to do with lower projected interest rates, which reduces spending on interest on the debt. In addition, lower projected health and food price inflation has reduced spending in Medicare, Medicaid, and food stamps, while lower enrollment has reduced projected spending in Social Security and unemployment insurance. On the revenue side, lower than expected economic growth has reduced how much the government is projected to bring in.

One big difference between February and now is about $150 billion less in spending/tax cuts for jobs measures. This is mostly because that amount went to extensions of the payroll tax cut and unemployment insurance which passed shortly after the Budget's release. In addition, some policies having later start dates results in lower costs being recorded.

Related to the payroll tax cut/UI extension, some offsets from the President's budget were used up to partially offset those costs and the cost of the transportation bill. Thus, policies such as increasing federal employee retirement contributions, auctioning spectrum, cutting Prevention and Public Health Fund spending, and increasing Pension Benefit Guaranty Corporation premiums have either disappeared or have had their savings reduced. Overall health and other mandatory spending savings dropped by $80 billion due to the already enacted policies and the previously mentioned lower baseline health spending growth.

On the tax side, the revenue-raisers overall raise slightly less than previously projected by about $30 billion. Presumably, this is due to lower projected growth, which reduces the revenue raised from provisions targeting high-income earners. Allowing the upper-income tax cuts to expire will now raise about $15 billion less than previously expected ($950 billion vs. $965 billion) and other revenue proposals will now raise about $15 billion less ($945 billion vs. $960 billion).

2013-2022 Impact of Policy Changes in President's Budget (billions)

OMB

MSR

Adjusted Baseline Deficits

-$8,665

-$8,305

Jobs Measures

-$175

-$195

Health and Other Mandatory Proposals

$595

$515

Allow Upper-Income Tax Cuts to Expire

$965

$950

Other Revenue Proposals

$960

$945

Draw Down War Spending

$850

$835

Repeal Sequester

-$965

-$965

Other Spending Changes

$60

$60

Other Tax Reductions

-$350

-$355

Net Interest

$175

$205

Total Deficits

-$6,685^

-$6,445^

Source: CBO, OMB, CRFB calculations^This number accounts for a $45 billion timing shift of payments in 2022, although none of the subtotals include this shift

The overall result is that the President's total savings have gone down by about $120 billion; however, when including the effects of the jobs proposal in 2012, the MSR projects savings that are about $60 billion higher than the President's budget from 2012-2022.

Either way, though, the amount of savings is not enough to put our debt on a clear downward path over the long term. As we said:

With a fiscal cliff looming at the end of the year, the next several months present an opportunity for policymakers to work together on a sensible plan to both avoid the fiscal cliff while also controlling rising debt. The strength of the American economy and standard of living will suffer if they do not.

The Announcement Effect Club has a new member after this weekend—Fiscal Commission Co-Chair Alan Simpson. Simpson discussed the dangers of the fiscal cliff and the need for deficit reduction in an interview with Neil Cavuto. In particular, Simpson focused on the need for having a long-term plan: the direction and certainty it would provide the country would be very beneficial.

We don’t have to put stuff in legislative language before December 31st. But do a plan...

Germany has a plan. It may or may not be a good but the [bond traders] and the raters stay away. If we had a plan, you wouldn’t hear mumbling out of Fitch or Moody's or the rest of them. You wouldn't hear about a negative rise. They would be laying back in the weeds to see if we could do it.

The Announcement Effect Club is a group composed of those who have states that the U.S. could boost the economy in the short run if it provides a longer-term plan to address our federal debt. Considering the uncertainty from the fiscal cliff at the end of the year, announcing a long-term plan would be especially helpful at this time.

The Council on Foreign Relations has joined in on those warning of the dangers of the fiscal cliff due to hit early January and unsustainable rising levels of debt. The helpful "backgrounder" piece explains both the domestic, national security, and economic consequences of the cliff as well as some context to how we got to this point. If you haven't already seen our updated fiscal cliff paper, the appendices provide detailed analysis of the cliff's impact on the economy, defense spending, discretionary spending, taxes and Medicare.

Adding some clarity to the end of the year, CFR provides a timeline of the rapid sequence of events leading up to the cliff. The first round of fiscal provisions on December 31 includes the revenue measures—the expiration of the Bush tax cuts and the expiration of the payroll tax cuts—but also the sunset of unemployment benefits and payments to Medicare physicians undergoing a 27 percent cut with the expiration of the doc fix. Two days later on January 2, the sequester is due to go into effect. Finally, the debt ceiling is expected to be breached sometime in January through February.

Notice the small one-month window between when the "Lame Duck Congress" begins and adjourns. It will it difficult to address all of the decisions that will need to be made in a comprehensive debt reduction plan; thus, lawmakers should get to work as soon as possible.

While the cliff will have a damaging effect on the economy, long-run projections show that the rising federal debt has the potential to do far greater damage. The cliff has the potential to help our long-term prospects, but only if it forces Congress to come together with a bipartisan deal. As we said in our paper, quoted by the CFR, "Failure to make the hard but necessary choices now on our own terms will lead to much harder and more severe choices later."

The CFR backgrounder piece can be found here, and our cliff paper is available here.

Today is the 47th anniversary of the Medicare program, reminding us of the great challenge we face from our growing entitlement spending. If you've seen our long-term projections, it is pretty clear than any long-term debt reduction plan will have to address Social Security, and even more importantly the rising health care costs of Medicare and Medicaid. The population of the United States will be aging rapidly in the next couple decades, with baby boom generation already begining to retire. Bill Keller of The New York Timesmakes the case that the baby boomers must be part of the solution.

Some have argued that these entitlement programs cannot be touched, but a bipartisan solution is not realistic without some changes. Revenues would have to skyrocket, or more likely the rising cost of entitlement programs would be financed with debt—which will quickly become unsustainable. Keller argues that preservation of entitlement programs may even have the effect of reducing our long-term competitiveness, citing a study from the Third Way:

This brings me to a soon-to-be released study by the incorrigible pragmatists at Third Way, the centrist Democratic think tank. The study takes a familiar refrain and presents it with a graphic wallop. Though it was intended as a wake-up call, not an indictment of a generation, it can be read as both.

In 1962, we were laying down the foundations of prosperity. About 32 cents of every federal dollar, excluding interest payments, was spent on investments, only 14 percent on entitlements. In the mid-70s the lines crossed. Today we spend less than 15 cents on investment and 46 cents on entitlements. And it gets worse. By 2030, when the last of us boomers have surged onto the Social Security rolls, entitlements will consume 61 cents of every federal dollar, starving our already neglected investment and leaving us, in the words of the study, with “a less-skilled work force, lower rates of job creation, and an infrastructure unfit for a 21st-century economy.”

Centrists like those at Third Way and the bipartisan authors of the Simpson-Bowles report endorse a menu of incremental cuts and reforms that would bring down costs without hitting the needy or snatching away the security blanket from those nearing retirement. They include gradually raising the retirement age to compensate for the fact that we now live, on average, 14 years longer than when F.D.R. signed Social Security into law. They include obliging those of us who can really afford it to pay a larger share. They also include technical fixes like aligning the automatic cost-of-living formula with reality. To curtail the raging inflation of health costs, the government could better use its market clout to hasten electronic record-keeping, replace the fee-for-service model, reform medical malpractice laws and promote living wills.

Boomers will have a tough choice to make. The combination of mandatory programs and interest payments on the federal debt will equal revenues possibly as soon as 2024, leaving little room for discretionary spending. Without action, we have little room for investments that will pay off over the long run. Reform is never easy, but we cannot afford to place all of the burden on the next generation. Each generation will need to make a contribution to fix this problem, and that includes the baby boomers.

The OMB has released its Mid-Session Review (MSR), essentially a re-estimate of the President's budget taking into new legislative, economic, and technical factors since February. We also put out a paper breaking down the MSR.

This year's MSR shows ten year budget deficits that are $240 billion than estimated in the President's budget. In addition, debt as a percent of GDP is slightly lower at 75.1 percent in 2022, compared to 76.5 percent in February. This compares to 61.3 percent under current law and 85.1 percent under the CRFB Realistic baseline.

Driving these changes are a $500 billion ten-year drop in projected revenue, more than offset by a $741 billion drop in outlays. Most of these changes are the result of economic and technical changes. Slower projected GDP growth is mainly responsible for the decrease in revenue projections. On the other hand, lower than expected interest rates reduced spending on interest on the debt significantly. In addition, lower than expected health care and food price inflation reduced projected spending on Medicare, Medicaid, and Social Security, and lower enrollment reduced spending on Social Security and unemployment insurance.

Legislative changes are a minor portion of the overall effect. Although the payroll tax cut extension significantly increased deficits through 2022, many of the deficit-increasing policies and some of the offsets were already included in the President's budget. As a result, the legislation only affected projected deficits by $1 billion. In addition, the transportation bill reduced deficits by $5 billion over ten years.

Overall, the MSR shows debt on a slightly downward path over the medium term, but it is still at a high level as a share of the economy. Furthermore, based on OMB's long-term budget outlook, debt would almost certainly resume rising beyond the ten-year window. In short, the MSR shows that the President's budget is a start, but it does not get us all the way there. What would? As our paper says:

When a bipartisan deficit reduction plan is agreed to, it should go much further than the President by bringing the debt down to a lower level and putting it on a clearer downward path over the medium term. That plan should also do more to slow the growth of entitlement spending over the long-term.

With a fiscal cliff looming at the end of the year, the next several months present an opportunity for policymakers to work together on a sensible plan to both avoid the fiscal cliff while also controlling rising debt. The strength of the American economy and standard of living will suffer if they do not.

According to POLITICO's Jake Sherman and John Bresnahan, lawmakers are nearing a deal that would fund the government for the first six months of FY 2013 (through the end of March). That deal would set the level of discretionary spending at the level specified in the Budget Control Act, $1.047 trillion, in a continuing resolution. Apparently, neither side wants to alter last year's deal until after the election.

On the positive side, at least it will get appropriations out of the way temporarily, and it will avoid a last-minute shutdown-averting deal. Of course, it also means that no appropriations bills will get passed until next year, if at all in 2013. It does not mean much in the aggregate, but it once again means poor budget governance and little prioritizing among discretionary spending.

The budget process clearly needs fixing. The Peterson-Pew Commission on Budget Reform issued its recommendations last year about how to improve the budget process so that lawmakers are forced to actually take a look at it annually. It would certainly be a great improvement over the current system.

In light of the Commission on Presidential Debates announcing the debate format for this year's presidential cycle, CRFB once again called for a debate where the two presidential candidates present detailed plans for reducing the debt. The three debates will have one focused on foreign policy, one on domestic policy, and one "town hall-style" debate. We will focus on getting the debt prominently featured in the latter two, but it also merits discussion in the foreign policy debate, given that Adm. Mike Mullen and others have said that the national debt is our greatest national security threat. Considering the importance of the issue going forward, it is crucial for voters to know how each candidate would go about stopping the rise of debt relative to the economy.

Under reasonable assumptions, if nothing is done, public debt will equal the size of the economy next decade and will be double the size of the economy by the 2040s. The "fiscal cliff" that is scheduled to hit at the end of the year would chip away at the debt, but at the cost of a recession next year. It is important that candidates lay out a plan that avoids both the fiscal cliff and the mountain of debt ahead.

Thousands of people have signed our Debate the Debt petition, including former Members of Congress and prominent budget experts, because they all want to see the candidates deal with the debt, not duck it. As CRFB President Maya MacGuineas said: "Taxpayers want to hear detailed plans of how each candidate would handle what experts have called the most predictable and most avoidable economic crisis in history."

The Concord Coalition has just unveiled a new paper, authored by Edmund Andrews, Joe Minarik, and Diane Lim Rodgers, called "Not Just Their Problem: The Euro Debt Crisis and U.S. Fiscal Policy," shedding some light on our fiscal outlook in an international context. The release of the paper was accompanied by an event hosted by the Concord Coalition and the Committee for Economic Development, including a speech from Senator Kent Conrad (D-ND) and a panel discussion featuring Douglass Elliot of the Brookings Institution, Simon Johnson of MIT, Joe Minarik of the Committee on Economic Development, and Diane Lim Rodgers from the Concord Coalition.

The Eurozone debt crisis is in the news every day, and the Concord paper offers a good overview of how a potential crisis could affect the U.S. while offering relevant lessons for the United States and its future fiscal policy. The United States may have been able to weather past international economic crises, but U.S. exports have been one of the largest drivers in this recovery. Not only does the euro crisis pose a threat to exporters dependent on Europe, but also American companies that export to countries that are large trading partners of the Eurozone are at great risk as well. In its current fragile state, our economy would be unlikely to avoid a collapse of the Eurozone, and policymakers should take European weaknesses into consideration.

One of the other large concerns for the economy right now is of course the possibility of going over the fiscal cliff. Adding to the worrying projections of the cliff's impact on the economy are the experiences of the European austerity measures which have had hindered economic recovery. From the paper:

The United States can learn from the European experience that excessive budget austerity during a tenuous economic recovery can make things worse. In the long term, however, persistently high deficits will undermine confidence, drive up interest rates and choke off growth in the nation’s productive capacity. We must find the delicate balance between: (i) adequately supporting the demand side of the economy in the near term, and (ii) making credible commitments to policies that will reduce budget deficits and increase supply-side growth over the longer term.

The European experience is proof that sudden austerity measures, like those that are set to occur under the fiscal cliff, are poor policy in a weak economy. But that is not the type of deficit reduction plan that is being discussed. If we put in place a plan that replaces the cliff with more gradual deficit reduction, we can avoid the immediate austerity set to take effect and austerity down the road that may be forced on us if we do not address the debt at all. Furthermore, there would likely be at least some positive short-term effect to announcing a plan now that will take effect only gradually.

One of the key indicators for debt sustainability is the level of interest to revenue. As shown in the graph above, by 2030, our fiscal outlook will be rapidly deteriorating and with a substantial risk of passing the 30 percent interest to revenue threshold, a level at which a fiscal crisis could become a very real possibility. Making the needed changes will not be easy. Simon Johnson commented that anyone who thinks that we can solve this problem without addressing revenues or entitlements is not being realistic. That adds a tremendous political challenge to the economic one. We will need leaders in Congress to step up and reach a bipartisan deal for long term debt reduction.

Yesterday the Senate voted on two highly polarized tax plans, with a Democratic version passing 51-48 while the Republican supported bill failing to pass 45-54. Neither were paid for—the Republican plan cost $405 billion and the Democratic plan cost $250 billion ($368 billion including excluded elements)—nor took any initiative on long-term deficit reduction. But bucking party affiliation were Senators Joe Lieberman (I-CT) and Susan Collins (R-ME), who voted against both tax cut plans on the grounds of good tax policy and fiscal sustainability.

Collins criticized Congress for trying to score political points instead of coming up with a fiscally responsible solution that would have a chance of passing. Collins stated:

“Congress needs to undertake comprehensive tax reform to make our system fairer, simpler, and more pro-growth. Instead, today we are asked to consider two proposals—neither of which represents my view and neither of which is a serious tax policy. Instead, they are election-year political ploys designed not to move us forward, but only to score political points.

“Our nation’s tax code needs to be overhauled, from top to bottom. The tax plan offered by the bipartisan Bowles-Simpson Commission – a commission the President himself created – offered a proposal a year and a half ago that should have been the foundation for a serious debate for such an overhaul."

Lieberman also voted against both plans, arguing that deficit reduction should be a priority of the Senate and that Congress cannot fail to act any longer. Said Lieberman:

"Today, I voted against both the Democratic and Republican tax proposals because they each fell far short of the comprehensive, bipartisan and balanced approach that is urgently needed to create jobs and restore economic growth. It is long past time to end the political posturing and begin the hard work of getting our deficit under control. To achieve that objective, it will require that all Americans make some sacrifices. It will require additional revenue and genuine entitlement reform. Fortunately, there is already a bi-partisan blueprint for action – the Bowles-Simpson plan – and I urge my colleagues to work together to forge an agreement along these lines. We have taken the political votes today, tomorrow we should begin work on a genuine plan to get our country out of this fiscal mess."

We are very encouraged by this move. Instead of simply kicking the can down the road, Senators Lieberman and Collins are standing up for fiscal responsibility. To be sure, going off the fiscal cliff by allowing all the tax cuts to expire and all the across-the-board spending cuts to take place isn’t a good idea—indeed it would put us into recession. But if we simply waive the fiscal cliff policies, we will doom ourselves to permanently higher debt and a permanently lower standard of living. We need to replace the fiscal cliff with a gradual and thoughtful deficit reduction plan that puts the debt and the economy on a sustainable path. We are proud to see that these two Senators recognize this reality.

Last week, our "Spotlight on the States" blog post highlighted structural challenges for the states, one of them being an eroding sales tax base. The inability of states to collect sales taxes on online sales, which we also have previously discussed, is one factor in that erosion (in addition to the growth of service consumption). In Quill Corp. v. North Dakota, a 1992 Supreme Court case, the Court ruled that states could not collect sales taxes on sellers who did not have a physical presence in the state. Only legislation from Congress could allow states to collect sales taxes from out-of-state sellers.

Yesterday, the House Judiciary Committee held a hearing on that very legislation, the Marketplace Equity Act, co-sponsored by Reps. Steve Womack (R-AR) and Jackie Speier (D-CA). Both Members testified at the hearing, arguing that allowing states to tax online sales would level the playing field for online retailers and "brick-and-mortar" stores with a physical presence in the state. Rep. Womack pointed out that the sales tax loophole turned stores into show rooms where people would examine merchandise and then go home and buy it online. Rep. Speier also pointed out that the increasing share of sales done online would financially burden states and localities as their revenue eroded.

Gov. Bill Haslam (R-TN) and state Rep. Wayne Harper (R-UT) echoed the points about state revenue and brick-and-mortar competitiveness; Haslam specifically said that the estimated revenue loss is about $20 billion per year. Both also addressed issues of complexity for retailers having to comply with different state and local tax codes by saying that tax software had advanced enough to handle that. In addition, Harper argued that federal requirements that states simplify their sales taxes could mitigate that concern--something the Act contains. Joseph Henchman of the Tax Foundation agreed that taxing internet sales may be desirable, but only if it is paired with conditions for the states and sales tax simplification efforts to prevent damaging interstate commerce.

However, Steve DelBianco, executive director of NetChoice (representing online commerce groups), argued that the Act would not level the playing field between online and offline sales. He said that traditional sales taxes are levied by the residence of the seller, but the Act would treat out-of-sales differently by levying it based on the residence of the buyer. He also pointed out the complexity issue of complying with many different state and local sales taxes, a conern that a few Members of the Committee also echoed. Finally, DelBianco argued that the $1 million exemption from the collection requirement was not high enough to prevent an undue burden on small businesses, that it should be raised to $15 million.

Considering that there is bipartisan support but also bipartisan concerns, it will be interesting to see where this bill goes in Congress.

The Senate is set to vote in the coming days on dueling one-year extensions of the 2001/2003/2010 tax cuts and Alternative Minimum Tax patch, with neither likely to go anywhere for now. Nonetheless, the Tax Policy Center has provided a helpful analysis of both plans in terms of both the distribution of tax cuts and a detailed breakdown of the Joint Committee on Taxation revenue estimates.

The breakdown is very helpful, showing side-by-side the cost of many of the provisions of each bill. On a comparable basis, the Republicans' plan costs about $40 billion more than the Democrats' plan ($405 billion vs. $368 billion), the differences stemming from extensions of the upper-income tax cuts, refundable tax credit expansions, and the estate tax parameters for next year.

Source: Tax Policy Center via JCT

The distributional tables show the distribution of the tax cuts for each proposal by income quintile. As expected, everyone gets a tax cut relative to current law, although the distribution differs and the narrative changes if you talk about a "tax-cuts-extended" current policy baseline.

Not surprisingly, the analysis shows that both of these plans would add hundreds of billions to the deficit -- and that is just a one-year extension. Most of the debate so far has focused on the differences between the two bills, but maybe they should devote more of their energy towards finding ways to offset these proposals. Better yet, our elected leaders could begin negotiating a way to replace the fiscal cliff with smarter and more gradual debt reduction.